The Relationship Between Executive Compensation and Firm Performance in Kenyan Banking Industry

Topics: Corporate governance, Board of directors, Executive compensation Pages: 53 (12792 words) Published: May 19, 2012

THE RELATIONSHIP BETWEEN EXECUTIVE

COMPENSATION AND FIRM PERFORMANCE IN

KENYAN BANKING INDUSTRY

Dr. Josiah Aduda, jaduda@uonbi.ac.ke, Lecturer and chairman, department of Finance and Accounting, School of Business, University of Nairobi, Kenya and Leonard Musyoka, University of Nairobi

Abstract
Economic theory of executive pay has focused on the design of optimal compensation schemes to align the interests of hired managers and shareholders. Agency theory has identified several factors by which these interests may differ; including the level of effort exerted by the manager and problems resulting from the unobservabilty of the agent’s relevant skills. The design of optimal compensation contracts essentially trades-off between different incentive problems and risk-sharing considerations. Research has also been directed to the identification of proper performance standards for evaluation and compensation.

The study sought to examine the relationship between executive compensation and firm performance. The study considered functional form relationship between the level of executive remuneration and accounting performance measures by using a regression model that related pay and performance. The findings of the study suggest that accounting measures of performance are not key considerations in determining executive compensation among the large commercial banks in Kenya and that size is a key criteria in determining executive compensation as it was significantly but negatively related to compensation. The negative correlation suggests the capping of executive compensation to ensure maximization of returns to shareholders.

Keywords: Executive Compensation, Firm performance, Agency theory

1. Introduction

1. Background of the Study

The relative importance of various factors used to measure the performance of agents should be related to how well each measure informs the principal about the agent’s actual performance (Banker and Datar, 1989). For decades accounting measures have been used as primary indicators of managerial performance with prior research documenting a significant relationship between accounting based performance and executive compensation (Ittner, et al., 1997). Moreover, both the annual cash bonus based compensation has been linked to accounting based performance as well as numerous other attributes of the firm’s governance structure (Core, et al., 1999).

The compensation literature suggests that most annual cash bonus plans for key executive officers are based in large part on accounting performance measures. There is also some relationship between accounting performance and stock based compensation in many firms since the pool of stock options or stock awards to be distributed each year is often based on annual accounting performance measures. The literature has also documented a high correlation in the total annual inceptive pay amongst the top executives in each firm, and it is commonly assumed that what is observed for the CEO is representative of the incentive pay for the entire top management team for most entities (Gore et al. 2003; Ittner, et al., 1997).

Based on prior work, much of the current executive compensation literature examines the relationship between CEO compensation and accounting based performance. In addition, these studies have documented links between executive pay and other attributes of firms related to their governance structure. These governance related variables have included firm size, number of board members, number of outside directors, number of interlocking directors, whether the CEO is also the Board Chair, and other governance characteristics (Core, et al., 1999). And commonly, accounting based performance measures tend to explain much more of the variance in executive pay across firms and time than do the governance characteristics (Core, et al., 1999). The relative importance of various factors used to measure...

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